Chapter 5 - Structured products on hedge funds

Abstract

Investors can benefit substantially by adding hedge fund strategies to their portfolios because of their diversification properties and absolute return objectives. Structured Products (SPs) on hedge funds evolved to serve the needs of a significant constituency of investors who were unable or unwilling to invest in hedge funds in the formats in which they were offered. The advantages of SPs over conventional hedge fund investments are that SPs can offer enhancements, such as superior risk management enhanced liquidity, access to leverage, and/or principal protection. These products can be thought of as having three distinct components: the underlying hedge fund asset, the payout, and the wrapper. The Hedge Fund Asset is either a fund of hedge funds or an index tied to a basket of hedge funds. The payout formula determines how the value of a product at maturity relates to the Hedge Fund Asset. The wrapper is the “packaging” of the SP, which may affect the tax and/or regulatory treatment of the product. One of the most difficult problems the providers of SPs linked to hedge funds face is the lack of transparency and liquidity associated with investing in Hedge Fund Assets. The most effective solution to this problem is to establish separately managed accounts with each manager that are segregated and managed in a manner similar to the manager's flagship fund. This gives the providers of the SP a much higher level of comfort in terms of transparency, risk monitoring, and liquidity.